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Losses expose risk management flaws

Rob Davies, Alexander Campbell and Jayne Jung

01 February 2008

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While the world waits for details on how a trader on Société Générale's arbitrage desk could notch up losses totalling EUR4.9 billion, early information suggests a monumental failure in risk management and control processes at the bank.

In the immediate aftermath, several questions have been raised: how was Jerome Kerviel, the trader allegedly at the centre of the scandal, able to build up positions totalling EUR50 billion in notional, and why did SG not ask serious questions when making the margin payments on those trades? Furthermore, why did the back office not pick up on fictitious over-the-counter trades the bank claims Kerviel used to mask his positions?

The trader had balanced a portfolio of directional futures trades on the Dow Jones Eurostoxx 50, Dax and FTSE 100 indexes with another portfolio of fictional opposing positions, making his overall risk appear low once the trades had netted out, the bank claimed. He camouflaged the existence of the second portfolio by selecting trades that did not require cash movements, margin calls or immediate confirmation, and falsified documents and computer system access codes. He also used a strategy of sequential cancellations of different trades, allowing him to roll trades over without being detected, the bank added. However, SG admitted the instruments in his first (real) portfolio had required margin payments, which the bank had made without becoming suspicious.

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Dealers at rival firms say they are stunned at the losses, suggesting a major breakdown between front and back offices. "In my experience, the back-office guys are on at you quickly if there is any discrepancy in a trade," says one London-based head of equity derivatives at a European bank. "This guy appears to have been a junior trader on the delta-one desk - not a business dealing in big risk. So how did he rack up such massive losses? It indicates severe failures in their internal processes, especially if they were forewarned about his activities."

Another London-based head of equity derivatives at a US bank believes backlogs in back-office processing of equity derivatives trades may have contributed to the problems. "Normally, when a trade is entered into the system, the back office contacts the counterparty and verifies the details. It is well known this doesn't always happen," the banker explains. "It doesn't happen for a variety of reasons - sometimes because counterparties won't confirm until you've sent a full confirmation from your side, or the back office on their side doesn't react until the trade is entered on their system."

According to the International Swaps and Derivatives Association's 2007 Operations Benchmarking Survey, the confirmation backlog in equity derivatives is significantly worse than other asset classes. The survey revealed only 14% of OTC equity derivatives were confirmed on trade date as of December 31, 2006, compared with 40% of currency options and 31% of credit derivatives. Additionally, the proportion of confirmations outstanding at equity derivatives dealers - the number of outstanding confirmations divided by the daily volume of new trades - was 13.7%. The equivalent proportion for credit derivatives was 4.9% over the same period.

Given the size of losses, it seems astonishing the back office did not uncover the deception sooner. However, Philippe Carrel, New York-based executive vice-president at Reuters Trade and Risk Management, says the reality is not straightforward.

"Futures exposures are often marked-to-market using profit/loss plus margin, not notional amounts because there is no presumed credit risk," he begins. "If you have someone able to allocate deals to fake portfolios and let him square himself before the end of day or next review of exposure limits, it will be difficult to spot. The back office would have just seen tiny spreads or amounts coming through on margin accounts."

Even so, dealers say the back office should, in normal circumstances, be able to pick up on trading activity of this magnitude. "The only explanation for why the back office did not pick anything up is that he had opportunities to hack into the system. He seems to have been able to create the trade in the front-office system and remove it from the back office so no-one noticed," believes Jean-Baptiste Guademet, London-based professional services manager at risk management solutions provider Sophis. "For that, he would need information on how different systems worked and password access."

Both Guademet and Carrel argue that any institution using separate platforms for the front and back office - with little transparency between them - could be manipulated.

Some dealers claim it is unlikely similar problems could emerge at their own firms. Nonetheless, most have begun reviews into their own processes to check for weak points. While one head of investment banking at a rival firm argues there isn't much a firm can do to prevent rogue trading, he says the key is identifying problems before they multiply.

"If somebody's bloody-minded enough to hide stuff, it is like the proverbial suicide bomber - it is difficult to prevent it. You just have to catch it quickly," he says.